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Chapter I:1
An Introduction to Taxation
Discussion Questions
I:1-1 The Supreme Court held the income tax to be unconstitutional in 1895 because the
income tax was considered to be a direct tax. At that time, the U.S. Constitution required that an
income tax be apportioned among the states in proportion to their populations. This type of tax
system would be extremely difficult to administer because different rates of tax would apply to
individual taxpayers depending on their states of residence. p. I:1-2.
I:1-2 The pay-as-you-go withholding was needed in 1943 to avoid significant tax collection
problems as the tax base broadened from 6% of the population in 1939 to 74% in 1945.
Pay-as-you-go permitted the federal government to deduct taxes directly out of an employee's
wages. p. I:1-3.
I:1-3 Under a progressive tax rate structure, the tax rate increases as the taxpayer's income
increases. Currently, for 2023, tax rates of 10%, 12%, 22%, 24%, 32%, 35% or 37% apply
depending upon the taxpayer's filing status and taxable income levels. Under a proportional tax
rate or "flat tax" structure, the same tax rate applies to all taxpayers regardless of their income
levels. Under a regressive tax rate structure, the tax rate decreases with an increase in income level.
The concept of vertical equity holds that taxpayers with higher income levels should pay a higher
proportion of tax and that the tax should be borne by those who have the "ability to pay." Thus,
Congressman Patrick's opposition to the flat tax is philosophically correct; under a flat tax system,
all taxpayers pay taxes at the same rate, regardless of the ability to pay. pp. I:1-4 and I:1-5.
I:1-4 It is possible for the government to raise taxes without raising tax rates. Because there
are two components in computing a taxpayer's tax, the tax base and the tax rate, taxes can be
raised by increasing either the rate or the base. Thus, even though the Governor proclaimed that
tax rates have remained at the same level, adjustments to the tax base, such as the elimination of
deductions, result in tax increases which can be as much, or more, as increases in tax rates. p.
I:1-4.
I:1-5 The marginal tax rate is of greater significance in measuring the tax effect for Carmen's
decision. The marginal tax rate is the percentage that is applied to an incremental amount of
taxable income that is added to or subtracted from the tax base. Through the marginal tax rate,
the taxpayer may measure the tax effect of the charitable contribution to her church. If her
marginal tax rate is 24%, she will save 24¢ for each $1 contributed to her church. The average
tax rate is simply the total tax liability divided by taxable income. pp. I:1-5 and I:1-6.
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I:1-6 Gift and estate taxes are levied when a transfer of wealth (property) takes place and are
both part of the unified transfer tax system. The tax base for computing the gift tax is the fair
market value of all gifts made in the current year minus an annual donee exclusion of $17,000
(2023) per donee, minus a marital deduction for gifts to spouse and a charitable contributions
deduction if applicable, plus the value of all taxable gifts in prior years. The tax base for the
estate tax is the decedent's gross estate, minus deductions for expenses, and a marital or
charitable deduction if applicable, plus taxable gifts made after 1976. pp. I:1-7 through I:1-10.
I:1-7 a.
Cathy, the donor, is primarily liable for the gift tax on the two gifts. The children
are contingently liable for payment of the gift tax in the event the donor fails to pay.
b.
Before considering the unified tax credit equivalent of $12.92 million for 2023, a
gift tax results on the two gifts for the current year 2023 computed as follows:
Total gifts
$100,000
Minus: Annual gift tax exclusion ($17,000 x 2 donees)
( 34,000)
Gift tax base
$ 66,000
Since Cathy has never made gifts in prior years, no gift tax will be due because of the substantial
unified tax credit that is available. pp. I:1-8 and I:1-9.
I:1-8 Carlos would report a taxable gain of $2,000 ($27,000 - $25,000). His tax basis in the
stock that he inherited is the fair market value on the date of his father’s death. pp. I:1-9 and I:110.
I:1-9 a.
Most estates are not subject to the federal estate tax because of generous credit and
deduction provisions, such as the unified tax credit and the unlimited marital deduction. The
unified tax credit equivalent for 2023 is $12.92 million. This means that, at a minimum, for
decedents dying in 2023, no estate of $12.92 million or less will be subject to the federal estate tax.
b.
This is a controversial question that has proponents on both sides of the issue.
Those that believe the estate tax should be reduced or eliminated basically argue that the estate
tax is a double tax, that is, the property of the decedent has already been subject to income
taxation during his or her lifetime and should not be subjected to further taxation at death. On
the other hand, proponents of retaining or increasing the estate tax believe in the ability to pay
principle. p. I:1-10.
I:1-10 a.
Progressive.
b.
Progressive.
c.
Proportional.
d.
Proportional.
e.
Proportional. (However, state and local sales taxes are considered regressive when
measured against income).
pp. I:1-4 and I:1-5 and I:1-12.
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I:1-11 Decrease. When Carolyn operates her business as a sole proprietor, she is considered to
be self-employed. A self-employment tax is imposed at the rate of 15.3% for 2023 (12.4%
OASDI + 2.9% Medicare) on all of her business income with a ceiling on the non-hospital
insurance (OASDI) portion of the tax base of $160,000 in 2023. Carolyn is also entitled to an
income tax deduction equal to 50% of the self-employment tax payments if she is self-employed.
If she works as an employee, however, the OASDI and Medicare taxes are imposed at the
employee level at a rate of 7.65% for 2023. The OASDI is imposed on earned income up to a
maximum of $160,200 in 2023 while Medicare taxes have no ceiling. Her employer would have
to match Carolyn’s OASDI and Medicare taxes. Thus, Social Security taxes are levied at the
same rate of 15.3% (7.65% on the employee and 7.65% on the employer). If the corporation
does not pay Carolyn a salary equal to its earnings, the Social Security taxes will be slightly less
than under the sole proprietorship. The hospital insurance portion of the FICA premium
continues to apply with no ceiling amount for employees, employers, and self-employed
individuals. The rate is 2.9% for self-employed individuals and 1.45% each for employees and
employers. p. I:1-11.
I:1-12 a.
Property taxes are primarily used by local governments and include both real
property taxes (real estate) and personal property taxes (tangible and intangible property).
b.
Excise taxes are primarily used by the federal government and are imposed on
items such as alcohol, tobacco, telephone usage, and many other goods. While not as extensive
as the federal government, many state and local governments impose similar types of taxes.
c.
Sales taxes are primarily used by state governments and constitute a major
revenue source for many states. Local governments are increasingly using sales taxes as well as
states. The local governments frequently tack-on 1¢ or 2¢ to the existing state sales tax rather
than imposing a separate sales tax.
d.
Income taxes are the primary domain of the federal government and constitutes its
major source of revenue. However, many state and local governments now use the income tax in
their revenue structures.
e.
Employment taxes are primarily used by the federal government. Social security
(FICA) taxes are a major source of federal revenue. Unemployment taxes are used by states as a
compliment to the federal unemployment compensation tax. pp. I:1-10 and I:1-11.
I:1-13 a.
The five characteristics of a “good” tax are equity, certainty, convenience,
economy, and simplicity. Equity refers to the fairness of the tax to the taxpayers. A certain tax
is one that ensures a stable source of government revenue and provides taxpayers with some
degree of certainty concerning the amount of their annual tax liability. Convenience refers to the
case of assessment, collectability, and administration for the government and reasonable
compliance requirements for taxpayers. An economical tax requires minimal compliance costs
for taxpayers and minimal administration costs for the government. Simplicity means the tax
system is simple to understand and to comply.
b.
1.
The federal income tax meets the first four criteria reasonably well, even
though many critics would suggest otherwise. The tax is reasonably fair in that the high-income
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taxpayers pay the most tax, the low-income taxpayers the least tax. While tax laws are
constantly changing, most taxpayers have a pretty good idea of what their taxes are going to be
for the tax year and the federal income tax does provide the government with a stable source of
revenue. The tax is convenient to pay although compliance requirements for taxpayers have
risen steadily over the years. The tax is economical for the government to collect; however, the
cost of compliance for taxpayers is much too high as approximately 56% of all taxpayers pay a
tax preparer to prepare their tax returns. However, virtually no one would suggest that the
federal income tax law is simple. In fact, complexity is one of the law’s major flaws.
2.
The state sales tax meets the criteria of certainty, convenience, economy
and simplicity quite well. However, the sales tax is criticized as not being equitable as it tends to
fall more heavily on lower and middle-income taxpayers.
3.
Property taxes do not fare well according to the characteristics of a “good”
tax. From equity standpoint, the property tax is imposed on property owners without regard to
their income situation. Thus, a farmer may have substantial property but little income to pay the
property tax. Property taxes are certain but clearly not convenient in the sense that they are
normally assessed in a lump-sum amount once a year. Property taxes do not meet the economy
criteria. Property taxes are rather simple although differences in judgments as to valuation of
property are a problem. pp. I:1-12 through I:1-14.
I:1-14 a.
Horizontal equity refers to the concept that similarly situated taxpayers should
pay approximately the same amount of tax. Vertical equity, on the other hand, refers to the
concept that higher income taxpayers should not only pay a higher amount of tax but should pay
a higher percentage of tax. Vertical equity is based on the notion that taxpayers who have the
“ability to pay” (e.g., higher income taxpayers) should pay more tax than lower income
taxpayers.
b.
Fairness is an elusive term. Because of widely divergent opinions as to what
constitutes fairness, it logically follows that there are also many different and divergent opinions
as to what constitutes a “fair” tax structure. p. I:1-13.
I:1-15 Secondary objectives include the following:
a.
Economic objectives such as stimulating private investment, reducing
unemployment, and mitigating the effects of inflation.
b.
Encouraging certain activities such as research and development and small
business investment.
c.
Social and public policy objectives, (e.g. encouraging charitable contributions and
discouraging illegal bribes). pp. I:1-14 and I:1-15.
I:1-16 Probably not. It would be difficult to achieve a simplified tax system and also provide
incentives to certain industries as well as achieve social objectives. To achieve a simplified tax
system would require the elimination of special purpose provisions, such as with the several
consumption tax proposals being forwarded. But consumption taxes generally are considered
unfair as they fall disproportionately on the low and middle class. pp. I:1-14 through I:1-16.
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I:l-17 Taxpaying entities generally are required to pay income taxes on their taxable income.
The major taxpaying entities are individuals and C corporations. Flow-through entities generally
do not directly pay income taxes on their taxable income but merely pass the income on to a
taxpaying entity. The major flow-through entities are sole proprietorships, partnerships, S
corporations, limited liability companies (LLC), limited liability partnerships (LLP), and certain
trusts. Some entities do not neatly fall within each category and are actually hybrid entities. S
corporations, for example, are subject to income taxes in certain situations, such as taxes on
built-in gains, the LIFO recapture tax, etc. Not many S corporations incur these taxes. pp. I:1-16
through I:1-24.
I:1-18 Sally and Tom’s taxable income for 2023 would be $62,300, computed as follows:
AGI
$ 90,000
Larger of itemized deductions ($10,000) or standard
deduction ($27,700)
(27,700)
Taxable income
$ 62,300
If Sally and Tom had itemized deductions of $30,000 rather than of $10,000, their taxable
income would be $60,000, computed as follows:
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AGI
Larger of itemized deductions ($30,000) or standard
deduction ($27,700)
Taxable income
$ 90,000
(30,000)
$ 60,000
As can be seen previously, the standard deduction of $27,700 is larger than $10,000 of their
itemized deductions, so they obviously would claim the standard deduction. Alternatively, if the
itemized deductions were $30,000, their taxable income would be $60,000 ($90,000 - $30,000)
as the itemized deductions exceed the standard deduction of $27,700. Taxpayers are allowed to
deduct the greater of itemized deductions or the standard deduction. pp. I:1-6, I:1-7, and I:1-17.
I:1-19 To properly respond to Bruin, tax calculations for both Bruin Corporation and John Bean
must be made for the year.
$400,000 dividend. If the $400,000 is distributed to John as a dividend, Bruin Corporation
would get no deduction for the dividend and would have corporate taxes of $105,000 ($500,000
x 0.21) based on taxable income of $500,000. John would then pay a maximum rate of 20% on
the dividend because his taxable income is greater than $492,300 given the tax bracket he is in,
so the income taxes due by John on the $400,000 dividend would be $80,000. Thus, the total
income taxes would be $185,000 ($105,000 + $80,000).
$400,000 salary. If the $400,000 is distributed to John as a salary, Bruin Corporation would be
allowed a deduction and the corporation’s taxable income now would be $100,000. The
corporate tax on $100,000 is $21,000. John would be required to pay income taxes on the
$400,000 at 37%, so the tax would be $148,000. The total income taxes for the year would be
$169,000.
As can be seen from the analysis above, the $400,000 salary would result in smaller taxes. This
results even though John is in the top 37% tax bracket. The tax savings would be even higher if
John were in a lower tax bracket. (Note that this solution ignores the incremental 3.8% tax on net
investment income for high income taxpayers, which is discussed in later chapters). pp. I:1-19 and
I:1-20.
I:1-20 The term “double taxation” refers to the taxing of the same income twice. This type of
taxation typically results from a C corporation paying tax on its taxable income and shareholders
paying income tax on any dividends received from the C corporation. The impact of double
taxation of C corporations has been substantially reduced by the fact that dividends generally are
taxed at a 15% rate with a maximum rate of 20%. An example of double taxation can be seen in
Example I:1-15 of the textbook. pp. I:1-19 and I:1-20.
I:1-21 Limited liability companies (LLCs) generally are taxed as partnerships. Therefore, the
LLC is not subject to income tax on its taxable income but such income is allocated to the
members (owners) of the LLC. Thus, only a single-level of taxation is imposed. The same
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allocation rules that pertain to partnerships also apply to LLCs. Another principle feature of
LLCs is limited liability for owners (members) of the LLC. pp. I:1-22 and I:1-23.
I:1-22 To prevent double taxation, the tax law allows partners to increase their basis in the
partnership for any income that is allocated to the partner. Since partnership distributions are not
subject to taxation if such distributions are less than the partner’s basis, double taxation is
prevented. Similarly, to prevent double deductions, the tax law requires partners to decrease
their basis for any loss or deduction that is allocated to the partner. pp. I:1-21 and I:1-22.
I:1-23 Schedule K-1 is an integral part of both the annual partnership tax return and the S
corporation tax return. Partnerships and S corporations use the same allocation system. The K-1
reports a partner’s allocable share of partnership ordinary income and separately-stated items, such
as dividends, long-term capital gains, etc. A K-1 is prepared for each partner in the partnership and
is filed with Form 1065. So, if a partnership has ten partners, there will be ten K-1s that allocate the
total partnership income to each partner. A copy of each partner’s K-1 is provided to the partners so
that they can report the information on their own tax returns. pp. I:1-21 and I:1-22.
I:1-24 Quint’s taxable income for 2023 is computed as follows:
Allocable share of PDQ Partnership income ($150,000 x .3333)
Other income
Adjusted gross income (AGI)
Standard deduction
Taxable income
$ 50,000
15,000
$ 65,000
$(13,850)
$ 51,150
The $30,000 distribution from the partnership is considered a return of capital and is not taxable
to Quint. Since he reports his allocable share of partnership income, if the distribution were
taxed again, the result would be double taxation. If the partnership is eligible for the 20%
qualified business income (QBI) deduction, Quint would also be allowed a deduction of $10,000
($50,000 x 0.20) for his share of partnership income. pp. I:1-17 and I:1-21.
I:1-25 Because of the vast volume of tax law sources, it is nearly impossible for any person to
have recall knowledge of the entire tax law. Thus, the ability to understand what the relevant
sources of tax law are, their relative weight (importance), and where to find the sources are vital
to a person working in the tax area. p. I:1-24.
I:1-26 Even though the Code is the highest authority of tax law sources, the Code contains
general language and does not address the many specific situations and transactions that occur.
To resolve tax questions concerning specific situations, administrative rulings and court
decisions are an integral part of the income tax law. p. I:1-24.
I:1-27 a.
Ways and Means Committee (House of Representatives), Senate Finance
Committee (U.S. Senate) and the Joint Conference Committee.
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b.
Committee reports are helpful for two major purposes: (1) to explain the new law
before the Treasury Department drafts regulations on the tax law changes, and (2) to explain the
intent of Congress for passing the new law. pp. I:1-24 through I:1-26.
I:1-28 The National Office of the IRS issues revenue rulings to provide guidance to taxpayers
on specific factual situations, processes ruling requests from taxpayers (private letter rulings),
and prepares Revenue Procedures that assist taxpayers with compliance matters. Of course, the
National Office also provides administrative and human resources functions at the top level of
the organization. p. I:1-26.
I:1-29 Individuals most likely to be audited include those that may be involved in any of the
following situations:
• Individuals who are sole proprietors and incur significant expenses in connection with
the trade or business.
• Itemized deductions in excess of an average amount for the person's income level.
• Filing of a refund claim by a taxpayer who has been previously audited and the audit
resulted in a substantial tax deficiency.
• Individuals who are self-employed with substantial business income or income from a
profession such as a medical doctor. p. I:1-27.
I:1-30 a.
Rarely will the IRS review each line of Anya’s return. Audits of individual
taxpayers generally focus on selected items on the return. Note: In prior years, the IRS had a
Taxpayer Compliance Measurement Program (TCMP) where a small number of taxpayers were
selected by a random sample and their returns were audited on a line-by-line basis. These audits
were primarily for statistical purposes. Currently, this program has been abandoned. However,
the IRS now uses the National Research Program (NRP) to select returns for audit. The NRP
will update data compiled in the old TCMP audits and develop new statistical models for
identifying returns most likely to contain errors.
b.
Generally not all items on a return will be audited. All tax returns are initially
checked for mathematical accuracy and items that may be considered clearly erroneous. If
differences are noted the IRS sends the taxpayer a bill for the corrected amount. Upon an audit
of Anya's return, the IRS generally only examines selected items on the return. These items are
those that the IRS believes there is a possibility of error. p. I:1-27.
I:1-31 a.
The term "hazards of litigation" refers to the probability of winning or losing a
case if it goes to court.
b.
Because of the possibility that a case may be lost and the cost of litigation, both
the IRS and taxpayers frequently settle a case to avoid such possibilities. The IRS may also
decide to settle a case because it does not want to establish an unfavorable precedent of cases in a
specific area. A taxpayer may settle a case to avoid substantial legal and professional fees. p.
I:1-29.
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I:1-32 No, just because the taxpayer has filed a return and received a refund, the IRS may still
audit a taxpayer. Tax returns that are selected for audit generally are audited a year or two after
the return is received by the IRS. p. I:1-28.
I:1-33 a.
The statute of limitations remains open indefinitely if a fraudulent return is filed
or if no return is filed at all.
b.
The general rule for the disallowance of tax deduction items is that an assessment
may be made against the taxpayer within three years from the later of the date the tax return was
filed or its due date.
c.
A six-year statute of limitations applies if the taxpayer omits an item of gross
income that is in excess of 25 percent of the gross income that is reported on the return. p. I:128.
I:1-34 The best possible defensibly correct solution is one that is advantageous to the client but
is based upon substantial authoritative support (e.g., favorable court cases) even though the
position may be challenged upon audit by the IRS. p. I:1-30.
I:1-35 The four principal areas of activity for the profession of tax practice are: tax compliance
and procedure, tax research, tax planning and financial planning. Tax compliance and procedure
essentially consists of tax return preparation and assisting the taxpayer in dealing with the IRS.
Tax research is the process of developing the most defensibly correct solution to a tax problem.
Tax planning involves the process of reducing taxes so as to maximize a taxpayer's after-tax
return. Financial planning, while not exclusively related to tax, is an area for tax professionals to
assist clients with planning for their entire financial affairs. pp. I:1-29 through I:1-31.
I:1-36 a.
Because income taxes may exceed 50% of a taxpayer's income (including federal,
state, and local income taxes and Social Security taxes), taxes are an extremely important part of
the financial planning process. Any financial plan that does not carefully consider taxes is a
flawed plan.
b.
Because tax professionals see their clients at least once a year at a minimum
(preparation of their income tax returns) and are familiar with the client’s financial information,
this represents a perfect opportunity to perform financial planning. p. I:1-31.
I:1-37 No, the principal goal of tax planning is to maximize a taxpayer's after-tax cash flow, not
just the minimization of taxes due. For example, if a taxable investment generates a better return
after taxes are paid than a nontaxable investment, the taxable investment is superior even though
taxes must be paid. p. I:1-30.
I:1-38 Tax planning involves the evaluation of alternative courses of action. The evaluation of
alternative courses of action can be very time-consuming because of the numerous and complex
tax calculations necessary to arrive at an optimal solution. Using tax software has become an
essential tool in this process because of the speed and accuracy in which tax calculations can be
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made as well as data analytic methods to analyze large amounts of tax data. pp. I:1-30 and I:131.
Problems
I:1-39 a.
Income:
Salary
Business income
Interest income
$100,000
25,000
10,000
$135,000
Deductions:
Business expenses
Itemized deductions
Taxable Income
Tax
$9,500
20,000
29,500
$105,500
$18,720
Note: Tax-exempt bond interest is not taxable and itemized deductions are greater than the standard
deduction amount.
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b.
Marginal rate = 24%
Average rate = 17.74%
Effective rate = 14.34%
(From tax rate schedule)
($18,720/$105,500)
($18,720/($135,000 + $5,000 - $9,500))
c.
From a tax planning point of view, the marginal rate is the most important rate
because it measures the tax saving from each additional $1 of deduction (or additional tax from
each additional $1 of taxable income). pp. I:1-4 through I:1-7 and I:1-17 and I:1-18.
I:1-40. The income tax payable, average tax rate, and marginal tax rate for each amount for
2023 for married couples filing joint income tax returns is as follows:
a.
$2,200 + .12($30,000 - $22,000) = $3,160
Average tax rate: $3,160/$30,000. = 10.53%
Marginal tax rate: 12%
b.
$10,294 + .22($100,000 - $89,450) = $12,615
Average tax rate: $12,615/$100,000. = 12.62%
Marginal tax rate: 22%
c.
$74,208 + .32($375,000 - $364,200) = $77,664
Average tax rate: $77,664/$375,000. = 20.71%
Marginal tax rate: 32%
d.
$186,601.50 + .37($700,000 - $693,750) = $188,914
Average tax rate: $188,914/$700,000 = 26.99%
Marginal tax rate: 37%
Note: This problem clearly demonstrates the progressive nature of the federal income tax. The
average tax rate rises from 10.53% to 26.99% in this problem.
I:1-41 a.
Their marginal tax rate with $490,000 of taxable income is 35%. However, with
an additional $40,000 of deductions, their taxable income drops to $450,000, which would
reduce their marginal tax rate to 32% (for 2023, the 35% rate begins when taxable income
exceeds $462,500).
b.
Their tax savings using the 2023 Tax Rate Schedules and married filing jointly
would be computed as follows:
Tax on $490,000
$ 115,289
Tax on $450,000
(101,664)
Tax savings
$ 13,625
pp. I:1-4 through I:1-7.
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I:1-42 Betty’s taxable gift for the current year (2023) is $83,000 computed as follows:
Gift to daughter
Gift to husband
Total gifts during year
Annual exclusion ($17,000 x 2)
$34,000
Marital deduction ($40,000 - $17,000) 23,000
Taxable gifts
$100,000
40,000
$140,000
(57,000)
$83,000
Note: Charitable contributions are not subject to the gift tax. Thus, the contribution to her
church is not subject to the gift tax. pp. I:1-8 and I:1-9.
I:1-43 a.
follows:
The amount of Clay's taxable estate is $8,225,000. This amount is computed as
Gross estate
Minus: Funeral and Admin. Expenses
Debts
Taxable Estate
$8,500,000
(125,000)
(150,000)
$8,225,000
b.
The tax base for computing Clay's estate tax is $ 8,225,000, computed as follows:
Taxable estate
$8,225,000
Gifts after 1976
0
Estate tax base
$8,225,000
c.
If the tentative estate tax is $3,235,800, no estate tax is due, computed as follows:
Estate tax from rate schedule
Minus: Unified tax credit (2023)
based on an equivalent of $12,920,000
Estate tax due
$3,235,800*
(5,113,800)
$0
*[$345,800 + .40 (8,225,000 – 1,000,000)]
d.
Yes, because the aggregate value of the estate decreased during the six-month
period following the date of death, the alternate valuation date may be selected by the
administrator. The important factors in deciding whether to use the alternate valuation date are
(1) the amount of estate taxes to be saved, and (2) the impact on the beneficiaries’ income tax
situation. However, in this case, the alternate valuation date would not be necessary because the
estate tax using date-of-death value is zero.
Note: There can never be a tax refund even if the unified credit is greater than the tax liability.
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e.
If the gross estate was $18,500,000, the taxable estate and tax base would be
$18,225,000 ($18,500,000 - $125,000 - $150,000). The estate tax would be as follows:
Estate tax from rate schedule
$7,235,800
Minus: Unified tax credit (2023)
based on an equivalent of $12,920,000
(5,113,800)
Estate tax due
$2,122,000
pp. I:1-9 and I:1-10.
I:1-44 a. The corporate tax liability of KT, Inc. for 2023 would be computed as follows:
Gross income
Expenses: Operating expenses
Taxable income
$2,000,000
(800,000)
$ 1,200,000
Corporation tax ($1,200,000 x 0.21)
$ 252,000
The tax liability of Keith and his wife on their individual return for 2023 is as follows:
Dividend from KT, Inc.
Other taxable income
Adjusted Gross Income (AGI)
Itemized deductions
Taxable income
$350,000
130,000
480,000
(40,000)
$440,000
Income tax (joint return rate schedule):
Taxable income (above)
Minus: dividends
Taxable income without dividends
Tax from rate schedule on $90,000
Tax on dividends ($350,000 x 15%*)
$440,000
( 350,000)
$ 90,000
$ 10,415
52,500
$ 62,915
Thus, the total tax liability for both the corporation (Keith’s share of 50%) and Keith and
his wife is $188,915 ($126,000 + $62,915).
b.
as follows:
If the consulting business was organized as an LLC, the income taxes would be
KT, LLC
Gross income
Operating expenses
$2,000,000
( 800,000)
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Taxable income
$1,200,000
Income tax
$
0
LLCs are flow-through entities and are not subject to income taxes on the entity.
The tax liability of Keith and his wife on their individual return for 2023 is as follows:
Pass-through income from KT, LLC
($1,200,000/2)
Other
taxable income
Adjusted gross income (AGI)
Itemized deductions
Taxable income
$600,000
130,000
730,000
(40,000)
$690,000
Income tax (joint return rate schedule,
rounded)*
$ 185,289
*Keith would also be subject to self-employment taxes on the $600,000 from KT, LLC. This
amount is not shown in this problem. Self-employment taxes are covered later in this textbook.
In this case, as seen from the tax calculations above, when the consulting business is organized
as an LLC, income taxes are about the same (a decrease of $3,626, calculated as the difference
between their tax as an LLC of $185,289 minus their tax as a C Corporation of $188,915.) This
results even though the dividends are taxed at a rate of 15%. Also, the $700,000 of LLC
distributions ($350,000 each) are not subject to income taxation. pp. I:1-19 through I:1-23.
Note: This extremely simplified problem is intended to illustrate the effect of double taxation of
C corporations and shareholders. Prior to 2018, the tax effect was much more significant. The
reduction of C corporation tax rates to 21% (from 35%) has substantially reduced the tax
advantage of flow-through entities. However, the 20% deduction for flow-through entities
would further enhance the viability of flow-through entities.
I:1-45 Howard and Dawn’s taxable income and income tax liability for 2023 is computed as
follows:
Dawn’s salary
Allocable share of partnership income ($180,000 x 0.40)
Qualified dividends ($4,000 + $3,000)
Net long-term capital gain [($28,000 - $12,000) x 0.40]
Adjusted gross income (AGI)
Larger of itemized deductions or standard deduction:
Standard deduction, or
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$ 80,000
72,000
7,000
6,400
$165,400
$27,700
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Itemized deductions:
Mortgage interest
Real estate taxes
State and local income taxes
Charitable contributions ($1,600 + $3,000)
Taxable income
$13,000
6,000
3,300
4,600
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26,600
( 27,700)
$137,700
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Income tax liability (from tax rate schedules, see calculations below)
Income tax payments made during the year:
Tax withheld from salary
$12,500
Estimated tax payments
10,000
Refund
*$137,700 – (7,000 + 6,400) = 124,300; tax
Dividends and LTCG: ($13,400 x 0.15)
Total tax liability
$ 19,971*
22,000
$ 2,029
$17,961
2,010
$19,971
Note: The cash distributions of $150,000 are not subject to income taxation for the partners.
Also, Howard would likely be subject to self-employment taxes which are substantial. Selfemployment taxes are covered in Chapter I:14 of this textbook.
pp. I:1-17 through I:1-19.
I:1-46 Since Paul's return is filed late and the final balance due on the return is paid late (both
due on or before April 15, 2024), Paul is subject to further interest and penalties on his 2023
income tax return. Both interest and penalties are computed on the net tax due or, in this case,
$8,000 (the difference between the tax liability and the withholdings). The interest and penalties
are computed as follows (assuming a 7% interest rate on underpayments on tax and the return is
232 days late):
Interest:
$8,000 x 7% x 232/365 = $355.95.
There are two penalties to which Paul would be subject, a failure to file (timely) penalty
and a failure to pay the tax (timely) penalty. The late payment penalty is .5% per month to a
maximum of 25%; the late filing penalty is 5% per month to a maximum of 25%. However, both
penalties are not assessed together. If both penalties apply, the failure to file penalty is reduced
by .5%.
Failure-to-pay penalty (0.5% per month to a maximum 25%):
Based on filing the return 9 months late:
Tax due
$8,000.00
Lesser of (a) 0.5% × 9 or (b) 25%
×
4.5%
Failure-to-pay penalty
$ 360.00
Failure-to-file penalty (5% per month to a maximum 25%, reduced by the failure-to-pay
penalty for each month both penalties apply):
Tax due
Lesser of (a) 5% × 9 or (b) 25%
Failure-to-file penalty before reduction
Failure-to-pay penalty for 5 months*
$8,000.00
× 25%
$2,000.00
( 200.00)
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Failure-to-file penalty
$1,800.00
*0.5% × 5 months × $8,000 = $200.00. Because the 5% per month penalty has a 25%
maximum, it applied for only 5 months. See IRM Sec. 8.17.7.3.
Thus, Paul must pay an additional $355.95 of interest plus $2,160.00 ($360.00 + $1,800.00) of
penalties for filing the return late, for a total cost of $2,515.95 for filing late. Obviously, Paul
would be prudent to file his return in a timely manner. pp. I:1-28 and I:1-29.
I:1-47 a.
Of the three individuals, Connie would most likely be audited. Individuals who
have unincorporated businesses that produce significant tax losses are likely to get audited by the
IRS.
b.
Craig is not likely to be audited.
c.
Dale is not likely to be audited. However, it is likely that the Form 1099 will be
checked against the reported amount and the IRS Center will send Dale a bill for the corrected
amount of tax. p. I:1-27.
I:1-48 The statute of limitations will not prevent the IRS from issuing a deficiency assessment
for all three years of 2014, 2019, or 2021. Dan's taxes from 2014 can be assessed because the
statute of limitations remains open indefinitely if no return is filed.
The $40,000 of unreported gross income from 2019 is taxable. A six-year statute of limitations
applies if the taxpayer omits an item of gross income that is in excess of 25% of the reported
gross income. In this case reported gross income was $60,000. $40,000 is greater than $15,000
(0.25 x $60,000).
The $600 unsubstantiated business travel deduction is disallowed in 2021 and gross income will
be increased in 2021 because an assessment may be made against the taxpayer within three years
from the later of the due date or the date the tax return was filed. In this case the omission
occurred in 2021. p. I:1-28.
Tax Strategy and Critical Thinking Problem
I:1-49 Pedro is in a good position to begin a gifting program to his children. Since he has such a
significant portfolio of stocks and bonds, he could make annual gifts of $15,000 of stocks and
bonds in 2023 and future years to each of his children. The effect of these gifts is to shift the
dividends and interest from Pedro (at his high rate) to the children (at their low rates) as well as
removing these assets from Pedro’s estate upon his death. Since the children have no income,
the dividends and interest would be taxed to the older two children at the lowest marginal income
tax rates.
As will be discussed in Chapter I:2 of this text, the children will be taxed at special rates
for much of the income shifted to them per the so-called “kiddie tax.” Thus, the shifting of
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investment income is not effective for children under the age of 18 (or 24 and in college). Also,
Pedro and his wife can actually gift $32,000 ($16,000 x 2) per year for each child and over a few
years, a sizeable amount of assets can be transferred to the children. To protect the assets, the
gifts can be made to trusts rather than directly to the children to ensure that the children do not
make bad decisions during their youthful years.
There are many other aspects of this type of tax strategy, but this problem is intended to
demonstrate both the income and estate tax savings that can be accomplished through the making
of annual gifts.
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Case Study Problem
I:1-50
 The apartment buildings constitute a rental activity and are subject to the passive activity
rules of Section 469 of the Internal Revenue Code. Since Rick’s adjusted gross income
(AGI) is greater than $150,000 before the loss, he would be unable to currently deduct
the losses on his personal income tax return. Therefore, the $100,000 of losses in each of
the first three years would not be deductible. However, the losses would be considered as
suspended passive losses and would be available as a deduction against the rental income
in future years.
 The blueberry farm, while requiring a substantial cash outlay, would not result in as much
a loss as Rick believes. The reason is that most of the cash outlays must be capitalized
and, if allowed, depreciated over several years rather than deducted currently. The land
would not be depreciated at all. Both the equipment and blueberry plants must be
capitalized and depreciated. So, while he may not get as much of a current deduction, he
still would be able to claim the deductions in future years when the farm begins
generating revenue.
 Rick is correct about using appreciated stock as a charitable contribution. If he gave his
entire amount of stock to charitable organizations, he would receive a $200,000
charitable deduction in the year of the contribution. He would not be required to
recognize any of the appreciation as income on his tax return. See Section 170 of the
Internal Revenue Code for details.
Tax Research Problem
I:1-51 In CIR v. Court Holding Co. the main issue was whether the petitioner should have been
taxed on the gain realized on the sales of all its assets, or whether the sale was made by its
stockholders individually after distribution of the assets to them in complete liquidation. The
sole asset in the corporation was an apartment house. All of the outstanding stock was owned by
a husband and wife. Negotiations took place between the corporation, a sister and brother-inlaw, and lessees of the building to sell the property. Just prior to putting the sale in writing, the
corporation's attorney advised the husband and wife that this sale would cause a large tax to the
corporation. The next day the corporation declared a "liquidating dividend" which deeded the
property to the husband and wife, who in turn surrendered all of their stock. A sales contract was
then drawn between the husband and wife and the lessees of the building for sale of the property.
The $1,000 that was previously paid to the corporation was given to the husband and wife as a
down payment. The property was then conveyed to the lessees.
The Tax Court found that the corporation had not abandoned the sales negotiations. "A
sale by one person cannot be transferred for tax purposes into a sale by another by using the
latter as a conduit through which to pass title." The Supreme Court upheld the Tax Court's
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findings that the sale was actually a sale by the corporation and the necessary taxes were
imposed. The Supreme Court held that the incidence of the transaction depends upon the
"substance" of the transaction and that the separate steps previously described should be viewed
as a whole transaction.
In U.S. v. Cumberland Public Service Co. the issue was essentially the same. Who
actually made the sale, the corporation or the shareholders? The Cumberland Public Service
Company was in the business of generating and distributing electric power. A local cooperative
began to distribute power in the area serviced by Cumberland. The competing company had
more efficient means of generating electricity. Cumberland offered to sell all of its stock to the
competing company. The company refused the offer but countered with an offer to buy the
transmission and distribution equipment of Cumberland. Cumberland refused because under
such a deal it would have been subject to a heavy capital gains tax. Shareholders of Cumberland
offered to buy the corporate property and then sell the property to the competing corporation.
The Court of Claims found that the shareholders did actually make the sale and that at no time
was the corporation ever planning to make such a sale. In addition, the court held that the
liquidation and dissolution genuinely ended the corporation's activities and existence. The
Supreme Court upheld the Court of Claims findings.
While the Court Holding Co. and Cumberland Public Service Co. cases appear to revolve
around very similar facts, the courts have ruled that the steps of such transactions must be
explored as well as the end result. The Cumberland Public Service Company was able to show
that the liquidation and dissolution genuinely ended the corporation's activities and existence so
that the shareholders acted on their own behalf when they executed the previously contemplated
sale to the cooperative.
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